Be wary of South African value traps – Allan Gray

Local investors should be careful when investing in South African companies as there is a significant risk that they are value traps that will generate poor returns.

This is the view of Duncan Artus, the chief investment officer at Allan Gray, who spoke to 702’s The Money Show.

Artus is concerned that certain domestic stocks are at risk of becoming value traps where investors will not generate adequate returns in the foreseeable future.

A value trap is an asset that appears cheap, but instead of appreciating in value, it continues to underperform as its fundamentals deteriorate.

Put simply: The asset looks cheap now and in five to ten years’ time, it will still be cheap.

According to Artus, this is true of South African companies that rely on the local economy for most of their revenue.

For instance, the JSE is trading at a price-to-earnings ratio of 11.8 times which is below its long-term average of 15.4 times. However, local stocks are only “optically cheap”, according to Artus.

“South African companies look cheap, but poor economic performance means that investors are unwilling to assign high valuations to them”. This means they are unlikely to substantially appreciate in value.

Local stocks cheap for a reason

Local stocks are low for good reasons – the South African economy is not growing, and there is a high cost of capital.

According to Artus, South AfricAfrica’somic fundamentals are deteriorating due to a lack of structural reform.

“Inve“tors will only be enticed by the government finally making difficult decisions” whi”h place South Africa on a better economic grounding for growth.

The only way for local stocks to see substantial appreciation in real terms would be for the economy to grow or for the cost of capital to decrease significantly.

However, South African assets may also become too cheap to ignore for local asset managers, particularly foreign investors who benefit from a strong currency.

How to invest in such a scenario

According to Artus, there are more opportunities for investors outside of South Africa, with the JSE only making up 1% of the global market capitalisation.

Thus, Allan Gray is looking to diversify outside of South Africa by raising the offshore exposure of its funds and is mainly exposed to the United States.

However, investing offshore is also highly complex, with geopolitical tensions between the United States and China introducing high levels of market volatility.

There are also opportunities in the local market, particularly in companies that earn most of their revenue outside of South Africa and in stronger currencies.

Examples of companies like this include Richemont, Naspers, British American Tabacco, and AB InBev, among others.